Cheaper Energy, Pricier Wires

Shortly after covid hit the US and the work from home era began, I looked into buying a bottle of shampoo online. I used to always grab things like that at the drug store next to my office, so without an office to leave, I kept forgetting to buy it. Unfortunately, shipping would have more than doubled its cost, which I couldn’t stomach. Instead, I wrote “BUY SHAMPOO, IDIOT” on a post-it note and put it on my front door.

Increasingly, this is what buying electricity in the US may feel like.

Your electricity bill has two elements: the cost of generating power and the cost of delivering it. People typically assume their bill is mostly or exclusively driven by the former. Far off power plants produce energy, they sell it into the wholesale market, and those costs eventually get passed on to consumers.

In reality, the cost of building and maintaining all the infrastructure to get power to your house (transmission lines, substations, distribution networks, transformers, etc.) is a significant portion of your bill. In fact, when working with large energy across the country, I even see utility bills where a majority of costs are associated with delivery.

And one of the most slept on trends in the energy industry is that this portion is growing rapidly. According to the US Energy Information Administration,

“After adjusting for inflation, major utilities spent 2.6 cents per kilowatthour (kWh) on electricity delivery in 2010, using 2020 dollars. In comparison, spending on delivery was 65% higher in 2020 at 4.3 cents/kWh. Conversely, utility spending on power production decreased from 6.8 cents/kWh in 2010 (using 2020 dollars) to 4.6 cents/kWh in 2020.”

Put simply, generating power is getting cheaper while delivering it becomes more expensive. In this post I will show how the utility business model creates this situation, how it can meaningfully slow the energy transition, and why DERs must challenge the monopoly if we want to fix it.

Why’s this happening?

Generating power has been getting cheaper for the last 20 years. In the early 2000s we built a truly massive fleet of natural gas power plants, just in time for the fracking revolution to unlock enormous quantities of low cost fuel for them.

Also, wind and solar began to get super cheap, which led to rapid deployment. Even at relatively low market shares, wind and solar suppress wholesale energy prices because they have zero marginal costs. And thanks to incredible learning rates for these technologies, we can only expect this to continue.

But cheap gas, wind, and solar are not the full story — simultaneously, delivery costs are also increasing. Exactly why this is occurring is hard to succinctly answer. Experts will cite many factors, including replacing aging grid equipment, implementing new smart technologies, and building new transmission lines to access the best locations for wind and solar power.

However, there is another explanation of these costs that is more controversial among experts. Power delivery infrastructure is the last bastion of the electricity monopoly, and from it, utilities intend to grow.

For context, here’s a quick history of electricity regulation:

• Historically, the generation and delivery of electricity was a monopoly granted by the state. Utilities built everything needed for us to have electricity, and were allowed to earn a regulated and guaranteed return on all of that capex.
• During the 1990s, energy market liberalization swept across the nation. Under this new paradigm, utilities were removed from the power generation process. While building and maintaining the power delivery system was considered a natural monopoly for which the traditional regulatory model still made sense, generating power was now conceived as a competitive market, where many players would compete to drive down the commodity cost of electricity. Note that, this only spread to about half the country.
• In 2005 electricity demand growth stopped. After decades of consistent growth, energy efficiency and industrial offshoring kept electricity demand flat. This meant utilities couldn’t build more stuff for the purpose of delivering more power.

Since utilities couldn’t make money on power generation any more, and there was no new load to justify new delivery infrastructure they could earn a return on, the utility business pivoted to deploying more and more capital into delivering power for existing demand. This resulted in an increasing unit cost of electricity delivery.

To be fair, there are good reasons to deploy more capital into delivering power for existing load. Smart grid technologies like advanced metering infrastructure (aka “smart meters”) cost money. However, if used well, these technologies also should help reduce peak demand on the grid, meaning future load growth can be served with less new delivery infrastructure. Therefore, the utility’s natural incentive is to convince their regulators to allow for deployment of this smart technology, which is capex they can receive a return on, but then not fully utilize it. That way, any new demand which may materialize can still be served with even more capital investment.

In short, the utility’s incentive is to deploy capital inefficiently, and all of that effort has been almost exclusively focused on delivery infrastructure for decades.

Decarbonization is levered to cheap electricity

There are obvious downsides to electricity becoming more expensive. For industry, high prices hurt the bottom line. For residential consumers, one can be forced to choose between a credit card balance and keeping the heat on. But within the more specific context of electricity generation becoming cheaper while its delivery cost increases, the impact on electrification should be considered.

The term electrification is used to describe fuel-switching a fossil-fuel energy demand to electricity. The two most common examples of this are electric vehicles and heat pump electric heating. Both are considered by most in the energy sector to be essential parts of decarbonization. The idea is that if we switch as much energy use to electricity as possible, then unlike when using fossil fuels, we can clean up the electricity source.

One reason electrification is supposed to be economical (in addition to sustainable) is that making power through renewables and batteries is getting cheaper by the day. As the power system converts to these sources, electricity prices should come down, making electrification economics more attractive. Or so the theory goes.

But if delivery costs continue to increase at the current pace, they’ll eat any savings generated by large-scale solar and wind. This is a problem for decarbonization, when around 130 million Americans live in a state where replacing an old gas furnace with a heat pump would create higher energy costs than simply buying another gas furnace (ignoring the higher capex as well).

And this doesn’t just impact residential home electrification. Buried in the business model of virtually every new and exciting decarbonization pathway (direct air capture, H2 for steel and shipping, e-fuels for aviation, etc.) is the assumption of very low cost electricity inputs made possible by renewables. You can listen to this episode of The Interchange for a deep dive on the subject, but the quick version is if that cheap renewable energy input is to be accessed via the grid, then delivery costs once again become a problem.

If we want rapid climate action the cost of electricity needs to fall, but its delivery costs may get in the way.

Load Defection? More like load optimization.

Another outcome of rising delivery and declining generation costs is electricity users will try to avoid those delivery costs. This will be accomplished by building on-site power systems or migrating to locations adjacent to existing cheap energy generation.

The former is becoming commonplace. Homes and businesses are installing on-site solar and storage at a rapid pace, and while they may not realize it, they are doing so to avoid delivery costs. The economics of this choice are often superior to signing up for a grid-delivered power contract because each unit of energy generates value at the retail rate (inclusive of delivery costs) rather than wholesale rate. And as the march of technology learning rates continues, the quantity of locations where this choice makes sense will grow.

Simultaneously, load will begin to migrate to places where large wind and solar projects already exist, in attempt to offtake power directly. This has started to happen with new industrial energy loads like hydrogen production and crypto-currency mining because they are extremely sensitive to the cost of power. Soon, other new-build industrial sites will do the same. And eventually, when this dynamic becomes compelling enough, businesses will even consider moving from their existing facilities to capture low cost power directly from large-scale energy sources. If you can avoid the distribution grid, you will.

In the electricity industry we refer to this as load defection, for which the primary concern is the so called utility death spiral. If load defection accelerates, delivery utilities will experience significant decline in energy sales, necessitating rate increases to pay for fixed infrastructure costs. This leads to more load defection, and the cycles continues. This is considered problematic because it will leave those without on-site power systems shouldering the cost of the delivery infrastructure we all (including on-site energy users) rely on.

This argument has been used to levy prejudicial fees on customers with on-site generation, and while this may seem logical, it ignores a crucial consideration; short-run versus long-run costs.

It is true that existing grid delivery assets are fixed costs. Reducing energy consumption from the utility doesn’t reduce the cost of that infrastructure. Once it exists, we’re stuck with it. However, reducing energy consumption (at the right times, more on that later), absolutely does decrease the need for future delivery infrastructure. If the delivery infrastructure needs to support “x” peak load today, and 1.5x at some point in the future, then a 0.25x reduction today means we only need to support 1.25x in the future. While it doesn’t translate immediately into delivery infrastructure savings, it most certainly will over time.

This matters because, while load hasn’t grown for 15+ years, it is about to explode. Earlier I mentioned electrification to show how increasing electricity delivery costs are a problem for decarbonization, but what I didn’t describe was the extent to which this will transform our electricity system. A study from the National Renewable Energy Laboratory (NREL) found high levels of electrification (but not even full electrification) will result in the power system requiring between 2 and 3.5 terawatts of generation capacity, relative to our 1.1 terawatts today.

Doubling or tripling our generating capacity will require a ton of new delivery infrastructure. It follows that reducing load on-site with distributed energy will absolutely reduce total delivery system costs. In turn, this means distributed energy will help keep delivery rates low for everyone, which is a very different outcome than the dystopian utility death spiral narrative some would lead you to believe.

Load defection is good for the grid, because it makes room in our existing delivery infrastructure to accommodate electrification. That results in a more optimized, cheaper power system for all, while making successful decarbonization more probable.

Virtual wires, the next frontier of liberalization

Earlier we established that the core monopoly utility incentive is to deploy capital inefficiently. With this in mind, utilities aren’t an ideal choice to own or operate the distributed energy technologies that will keep delivery rates low in the face of huge new load growth from electrification.

Instead, a variety of market participants should develop these solutions and be financially exposed to their performance. For example, what is the best way to deploy a smart thermostat to shift demand patterns? If the utility installs it, or even just controls it, chances are it will never be properly utilized. But when an end-user or their company of choice installs it, because they’re taking the risk on it working, you can be sure they’ll do everything they can to achieve the best outcome.

Consider that about a decade-ago the utility sector and its regulators began talking about Non-Wires Alternatives (this concept). Over that time, a few pilots have taken place, and much ink has been spilled about them, but no sincere effort has been made to turn this into a scalable approach for managing grid infrastructure costs. The common thread across all of these pilots was utility management of the programs.

The case for this is no different than that which led to wholesale power markets. Providing the service of avoided distribution infrastructure, or virtual wires, is not a natural monopoly, so it would be sub-optimal to treat it as one.

One key challenge to achieving this future will be designing the right price signals to properly compensate virtual wires for the value they offer. Options include incorporating these future charges into electricity bills and letting users install DERs to reduce them (rate design), implementing programs that compensate virtual wires services providers directly via the rate base (a DSO type market perhaps?), tariff programs that transact through the utilities (like NY’s VDER), and likely many other things. Whatever the best price signal is, we should strive to make it clear and standardized across the country. If every regulatory fiefdom takes a different approach, we’ll wind up with high transaction costs and providers that can’t scale.

A second challenge will be that utilities likely won’t appreciate this vision. The existence of virtual wires is conceptually (not legally) a challenge to their franchise right, the state-granted monopoly for building electricity delivery infrastructure. This will invariably lead to policy battles that force us to reckon with the fundamental nature of the monopoly regulatory model. And this battle probably wont be fair, given when backed into a corner utilities are known to fight in distasteful (astroturfing) or even illegal (bribery) ways.

Despite these challenges, managing the delivery cost problem and the system change implied by its solution will be a major theme as electrification grows. If we want a power system that is prepared for the challenges of the future and supports human prosperity, we must be successful in this endeavor